On the Gold Standard & the Federal Reserve
The Financial Times published a report yesterday citing parts of the Republican party platform that I find quite alarming. Specifically, they note:
“Drafts of the party platform, which it will adopt at a convention in Tampa Bay, Florida, next week, call for an audit of Federal Reserve monetary policy and a commission to look at restoring the link between the dollar and gold.”
I’ll make this short and sweet because no one in their right mind wants to read about the Federal Reserve and the gold standard for more than 5 minutes. The rationale behind the existence of the Federal Reserve system is really rather brilliant. And moving off of the gold standard wasn’t brilliant, it was necessary.
First the Fed. The way the monetary system works is essentially with a two tiered money system. You have inside money or bank money (banks deposits – most of our money supply). And you have outside money or government money (cash, notes & reserves). Most of the money is inside money or bank money. Bank money can be inherently unstable just like the business cycle so it helps to have an entity that backs this system up in time of inevitable instability.
Back in the days before we had a central bank the banks were basically just issuing money and settling payments between themselves as they wished. The problem was that when JP Morgan issued JPM notes for a big railroad project and Joe Schmo used those notes to buy a drink at his local bar after hammering rail track for 9 hours the bar owner would look at the notes and sometimes say “sorry friend, but my bank doesn’t take JPM notes any longer because they’re worried about them thar railroad companies and the related financing”. Okay, I am probably simplifying things way too much there, but that’s essentially what happened on a massive scale during the 1800′s. It was literally the wild wild west of banking. And the result was 6 depressions and persistent banking crises. Then the Fed comes along and creates the reserve system which was basically a way of helping banks settle payments (well, it was implemented for much more than that, but this was one of the primary issues it resolved).
So banks could settle payments in what is called outside money or bank reserves. It’s kind of like having one big banking system rather than a bunch of different banks. The reserve system streamlined the settlement process and helped stabilize inside money to an enormous degree. When you understand the inner workings of the Fed it’s actually quite a remarkable construct and makes a great deal of sense. The persistent calls to “end the Fed” and such are built on a misunderstanding of the monetary system and what is really a call to empower private banks even further and bring back the wild wild west of banking. It doesn’t make sense.
As for the Fed auditing – well, they do get audited. So I don’t know why we need to keep harping on that….
As for the gold standard – well, that’s basically what Europe has going on right now. It’s a really lovely monetary construct that involves no floating exchange rates, a single currency, ties the hands of the government and results in persistent trade imbalances (oh, and results in depressions!). See, Europe has no floating exchange rates because they all use the same currency. And there’s no fiscal entity (like the US Treasury) that can offset the fiscal imbalances by distributing funds to those who need it. No floating FX and no Treasury means the trade imbalances must be rectified through market pricing mechanisms. The problem is, the market mechanism doesn’t work like all those neoclassicals wish it did. So the trade imbalances persist, the underlying economic imbalances persist and you get a result that’s a lot like Europe where depression basically makes itself nice and cozy. It’s a total disaster and trying to go back to a system like that is madness.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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99 Comments
The problem with floating exchange rates is that the rates are not defined by the markets. Every intervention of a central bank is politically motivated. We can see this on the stock markets. People just wait until Bernanke or Draghi make their statement and the market will move on the decisions made. This has nothing to do with a free market. Literately a hand full of guys decide what the exchange rate for all the dollars on earth will be… The fate of the dollar is in the hand of a few guys who think they’re smarter then the rest. I don’t think that this system is reliable in the long run. Somehow since the great recession central bankers think that the price of the stock market is equal the real economy. So Bernanke and Co. make everything to support the price of the stock market and ignore the real economy. They basically help just the “too big to fail” banks. But in fact all that money shifting didn’t really help creating sustainable jobs nor did it really help the average person on the street.
And what CR writes about the gold standard is really shallow. Mankind knows the gold standard for hundreds of years. And of course under a gold standard we had nations rise and fall, we had recessions, boom times and so forth. But the same happened under free floating rates. We had nations rise and fall, recessions, boom times… The problem is we know free floating exchange rates for only 39 years. Everyone claiming that this is the definitive way to go might be somehow biased or shortsighted.
Every system with fixed or floating exchange rates has advantages and disadvantages. Only time will show us if we are on the right path with free floating exchange rates.
And I’d like to say that since the definitive end of the gold standard in 1973 we had the excesses in the banking system. Inequality, not only in payroll, is higher then ever.
Of course no one can say if inequality wound’t be higher under a gold standard… But to praise free floating exchange rates seems to me too early. One can study every chart of stocks, prices and so forth but since 1973 everything went parabolic. Is this just a coincidence?
Of course I could go on with inequalities on this planet, but I’m not one of these extreme left-wingers which blame everything on capitalism or in this case on floating exchange rates. But one should just think about it.
As well it is shortsighted to say free floating exchange rates don’t create severe crisis. Everyone points to the great depression as an example of what the gold standard made and seems to forget what happens right now. BTW one can find many economist claiming that the great depression had nothing to do with the gold standard.
Everyone claiming that floating exchange rates are somehow better ignore the fact what all these people told us: With central banks and floating exchange rates we will have the power to prevent huge crisis and the economic cycles will be smoothed. And what happens right now? Aren’t we in a huge crisis? Now it would just be cynical to claim that the crisis in 1929 was bigger…
On average we had a recession every four years and this didn’t change since 1973.
I think CR is just to optimistic about MMT and floating rates and that our monetary system is just too complex to grasp even with the help of computer models. Only time will show us where we will end up with this very young system of floating exchange rate. Unfortunately I think that the biggest tasks and experiences we will make are still ahead of us.
http://www.project-syndicate.org/blog/gold–the-republican-death-wish-by-christopher-t–mahoney
I’m honestly disappointed with the arguments put forward in this article. Sounds almost like: I’m not going to think at all, I was brainwashed into believing this particular theory and I can tell you a little story that supports just that.
This topic has been debated back and forth over many decades and we still didn’t come to a conclusion on whether Fiat currency is “better” than a gold standard. And I highly doubt we will find the answer anytime soon. The main reason for that is that they are both good systems, each with their inherent flaws.
It’s like asking which car is better, a Volvo or a convertible?
It all depends on your needs and personality.
The main flaw for the gold standard is that it doesn’t allow much room for covering up malinvestments, political squandering and manipulation.
The Austrians call it honest money for a reason.
The main flaw for the Fiat system is exactly the opposite, it allows too much room for manipulation and misuse by those in charge when there is no oversight. We recently discovered that our system is entirely corrupt and manipulated. Even the most sacrosanct principles of a fiat currency and free market system have been disregarded during the crisis and are still disregarded until today.
The problem in Europe is not that they have a gold standard. They don’t.
The problem in Europe is that the Fiat currency system of the Euro has been misused for too long. Poor countries in the south spent way beyond their means in comparison to the countries in the north and are now confronted with a choice: change their practices or go back to their own currency (I don’t even dare counting the number of times Greece was bankrupt).
The other solution would be to have a political union, meaning rich countries pay for the poor countries as it is the case in the US where wealth is transferred from one State to the other.
Don’t you Gold Standard people get it. The GOLD STANDARD is government manipulation. Who decides the standard if not the government?